Monday, 30 June 2014

David Cameron has pledged that, if he wins the 2015 election,
he will spend the next two years renegotiating the UK’s terms of membership,
and then hold a referendum by the end of 2017. The Labour opposition has declined
to match this pledge. The UK business community, particularly those involved in
trade, is broadly against UK exit from the EU (‘Brexit‘). This
reflects the economic consensus, as outlined in a recent CEP study, that exit
would do serious harm to the economy (summary,
paper). Yet, as I noted recently, sections in the Labour party warn
that some of the opposition’s positions appear anti-business. I think events in recent days indicate that the real
concern for UK business should be a Conservative victory.

When Cameron’s referendum pledge was originally made, I think
many regarded it is essentially a short term political device to appease
sections within the Conservative Party and UKIP voters. They assumed that UK
renegotiation would be a largely symbolic affair, with any concessions the UK
received being in practice minor but enough for Cameron to claim something far
more substantial. Cameron would then be able to fully recommend staying within
the EU, and the referendum would be won.

I think that is a reasonable statement of Cameron’s original
intentions. The problem with this scenario is that it relies on a deceit:
portraying minor changes in EU terms of membership as somehow fundamental.
Traditionally a Conservative government can get away with this kind of thing
because it has the majority of UK newspapers behind it, and a BBC which is influenced by that press. In this case,
however, exactly the opposite will be true. Large sections of the UK press are
virulent in their opposition to EU membership.

The Juncker affair
illustrates the difficulty of the game being played. To attract the UKIP vote,
Cameron has to promote the idea that EU membership on current terms is a major
problem for the UK. He also seems to think that appearing as the only EU leader
prepared to stand up for principles, and portraying his EU colleagues as cowards in the face of German dominance, plays
well with the parts of the electorate he wants to win back. So having marched
the country to the top of the hill before the election, he has just two years
to march them back down again. That will be two years in which large sections
of the UK press will be throwing everything they have at achieving the
opposite, and where the news will be dominated by this renegotiation.

It is possible, of course, that he may actually achieve some
major changes to the UK’s terms of membership. But again, the recent episode
shows how difficult that will be. It appears as if Merkel changed her mind and
supported Juncker as a result of domestic political pressure. Even if she is
personally disposed to try and be helpful to Cameron, this experience suggests
she will not risk that much to do so. In addition, the more Cameron plays the
‘bulldog battling the EU monolith’ line, the more he builds opposition abroad
to ‘giving in to UK blackmail’. Calling potential allies cowards does not seem
like a wise thing to do.

There must also be risks on the other side. It is said that
almost half of all Conservative MPs will campaign to leave the EU. Conservative
party activists are likely to be much more anti-EU than MPs, so
considerable pressure will be placed on Cameron to tone down his eventual
support for a yes vote to stay in the EU. It is conceivable that he might
refrain from clearly backing continued EU membership, in frustration with his
EU colleagues after two years of negotiation and to keep safe his own position
in the party.

The current betting is that any referendum will result in a
vote to stay in, but the odds are close. What is clear is that a Conservative
victory that brings with it a referendum will lead to two years of heightened
uncertainty, and what business leaders always say is that they really dislike
uncertainty. The risk that the end result will be exit from the EU are
considerable, and that would lead to a further period of uncertainty as the UK
tries to negotiate favourable trade deals as an outsider. Is all this risk
really worth it just to ensure a lower top rate of income tax?

Saturday, 28 June 2014

In the account of the history of macroeconomic thought I gave here, the New Classical counter revolution was
both methodological and ideological in nature. It was successful, I suggested,
because too many economists were unhappy with the gulf between the methodology
used in much of microeconomics, and the methodology of macroeconomics at the
time.

There is a much simpler reading. Just as the original Keynesian
revolution was caused by massive empirical failure (the Great Depression), the
New Classical revolution was caused by the Keynesian failure of the 1970s:
stagflation. An example of this reading is in this piece by the philosopher Alex Rosenberg (HT
Diane Coyle). He writes: “Back then it was the New Classical macrotheory that
gave the right answers and explained what the matter with the Keynesian models
was.”

I just do
not think that is right. Stagflation is very easily explained: you just
need an ‘accelerationist’ Phillips curve (i.e. where the coefficient on expected
inflation is one), plus a period in which monetary policymakers systematically
underestimate the natural rate of unemployment. You do not need rational
expectations, or any of the other innovations introduced by New Classical
economists.

No doubt the inflation of the 1970s made the macroeconomic
status quo unattractive. But I do not think the basic appeal of New Classical
ideas lay in their better predictive ability. The attraction of rational
expectations was not that it explained actual expectations data better than
some form of adaptive scheme. Instead it just seemed more consistent with the
general idea of rationality that economists used all the time. Ricardian
Equivalence was not successful because the data revealed that tax cuts had no
impact on consumption - in fact study after study have shown that tax cuts do
have a significant impact on consumption.

Stagflation did not kill IS-LM. In fact, because empirical
validity was so central to the methodology of macroeconomics at the time, it
adapted to stagflation very quickly. This gave a boost to the policy of
monetarism, but this used the same IS-LM framework. If you want to find the
decisive event that led to New Classical economists winning their
counterrevolution, it was the theoretical realisation that if expectations were
rational, but inflation was described by an accelerationist Phillips curve with
expectations about current inflation
on the right hand side, then deviations from the natural rate had to be random.
The fatal flaw in the Keynesian/Monetarist theory of the 1970s was theoretical
rather than empirical.

Friday, 27 June 2014

An MP who is a member of the Treasury Select Committee has described the Bank of England as an unreliable
boyfriend: “one day hot, one day cold". City economists make similar
complaints. The same is frequently said in the US about supposed Fed
communication failures. Are these complaints justified?

In judging whether a central bank is really ‘blowing hot and
cold’, we need to distinguish between public information about the economy on
the one hand, and how policymakers will behave given new information on the
other (in technical terms, their ‘reactions functions’). If you start flirting
with your boyfriend’s best mate, you should not be surprised if he starts going
a little cold. If, on the other hand, he had been attentive and considerate
until the World Cup started, since when you have been completely ignored, you
have probably learnt something about him that you did not know before.

The problem is that we cannot know for sure how each MPC or FOMC member
will react to new bits of data as they emerge. So when Mark Carney in his
Mansion House speech said “There’s already great speculation
about the exact timing of the first rate hike and this decision is becoming
more balanced.” he could have just been reflecting the fact that recent data
had been surprisingly strong. As everyone had seen this data, there was no
useful additional information in that statement.

However he went on to say “It could happen sooner than markets
currently expect.” The intent of that statement is clear. For some reason
markets had not reacted to this recent data (and therefore advanced their
expectations about when the first rate increase would occur) in the way Mark
Carney or the MPC as a whole had done. So they had got the Bank’s reaction
function wrong, and Carney was telling them so.

This is why the market reacted strongly to Carney’s speech, and
Carney intended them to do so. The trick was to
reference something tangible - the market’s forecast for when interest rates
were likely to rise. But this raises an obvious question. If part of the Bank’s
communications strategy is to make comments about market forecasts of interest
rates, wouldn’t it be both clearer and more efficient to have the Bank’s own
forecast about interest rates. This is a point that ex-Bank economist Tony
Yates makes here.

I have argued for this for some time (e.g. here, para 105), and was therefore enthusiastic when the Fed started to publish
rate forecasts just after I started this blog. The idea is obviously not to
commit the central bank to some path: a forecast is a forecast. Nor is the idea
that the central bank somehow knows more about the data than the market, or
that its ability to forecast is better. What publishing
a forecast allows the market to do is get a better idea of character of their
‘boyfriend’. (It also allows the public to check that their boyfriend is not
being time inconsistent, as I also explain here.)

It is only a matter of time before the Bank of England does
this, and continues in its tradition of following the Fed. One interesting
question of detail remains, however. Should the Bank publish a single forecast,
or follow the Fed and publish the forecasts of each MPC member? (I give an
example of the FOMC ‘blue dots’ in this post.) There are arguments for both. The Bank
publishes a forecast for inflation and other aspects of the economy, but only
on the basis of market guesses of future rates. It would be much more efficient
and informative to publish forecasts based on the Bank’s best guess about the
future path of interest rates.

The problem with having just one forecast is illustrated by the
Carney speech. Was Carney at the time giving his view, or the view of the MPC?
If the latter, how unanimous was that view? If subsequently a member of the MPC
says something different, is that consistent with the majority view or a
change? This problem becomes particularly acute when new MPC members replace
old. Questions such as these can only be answered if individual MPC members
give their own personal forecasts, as FOMC members currently do but with, in
addition, their names attached.

When it comes to monetary policy, we have not one but many
‘boyfriends’. Now boyfriends can get annoyed if you keep asking them ‘what are
you thinking’, but in this case we do rely on them (and pay them) rather a lot,
so I think we are entitled to know.

Thursday, 26 June 2014

In a previous post I talked about why it made sense to keep
the form of the current government’s
fiscal mandate, although the five year rolling target should involve the
deficit rather than the cyclically adjusted current balance. But what about
actual numbers?

I start the analysis in financial year 2015/16, with the OBR’s forecast for headline public sector net
borrowing (hereafter the deficit) of 3.8% of GDP. Let us also assume that the
debt to GDP ratio at the beginning of that financial year is a nice round 80%
(the OBR’s forecast is slightly less). That is the deficit and debt that any
new government will inherit. Let us also assume that by that time interest
rates are above the Zero Lower Bound (ZLB) and are more likely to rise than
fall back to the ZLB. That is by no means certain, and in my view it is critical. If interest rates are
still stuck near zero, fiscal policy should be aiming to speed the recovery,
not reduce the deficit.

A deficit of 3.8% is too high to start bringing public debt
down, and the analysis outlined here or here suggests it makes sense to bring debt down.
So the key question is simply - how fast should the deficit and debt fall?

Year

Slow

Medium

Fast

Osborne

2015/16

0.038

0.038

0.038

0.038

2016/17

0.036

0.034

0.032

0.022

2017/18

0.034

0.03

0.027

0.009

2018/19

0.032

0.028

0.022

0

2019/20

0.031

0.026

0.018

0

2020/21

0.03

0.024

0.015

0

2025/26

0.025

0.015

0.005

0

2030/31

0.02

0.01

0.005

0

2040/41

0.01

0.005

0.005

0

Long run D/Y %

25%

12.5%

12.5%

0%

Alternative paths for
the deficit to GDP ratio

Economic theory only really tells us one thing on this
question: deficit reduction should be fairly slow, if there is no danger of
default. So in the table above I look at four possible paths. In the ‘slow’
path, the target for the deficit 5 years ahead made in 2015 would be 3% of GDP.
If we make the assumption that long run growth in nominal GDP is 4% a year,
then maintaining a 3% deficit would stabilise the debt to GDP ratio at 75% of
GDP. I think that is still too high, and for various reasons it is good to plan
for a steady fall in the debt to GDP ratio over the next few decades. So the
slow adjustment path involves a steady but slow reduction in deficits to 1% of
GDP by 2040, which if maintained would eventually stabilise the debt to GDP
ratio at 25%. The path of debt, assuming 4% nominal growth each year, is shown
below.

This ‘slow’ path is much slower than anyone is currently
talking about, but I’ve included it just to make the point that it should be an
option that is on the table and seriously considered. It gets debt down to a
smaller share of GDP than at any time in the UK over the last two hundred
years. It may do so too slowly, but it is important to discuss why it is thought
to be too slow.

The path labelled medium is more ambitious in two respects.
First, the five year target made in 2015 is a deficit of 2.4% of GDP rather than 3%,
so the pace of deficit reduction from 2015 is more ambitious. Second, the
target is an eventual debt to GDP ratio of 12.5% of GDP. So the deficit is
steadily reduced to 0.5% of GDP. However both of these paths fail to noticeably
reduce debt by 2020 compared to 2015. (With 4% nominal growth, and starting with
debt to GDP at 80%, the deficit needs to be below 3.2% for debt to start
falling).

The ‘quick’ path involves a deficit target of only 1.5% by
2020, and further reductions so that the deficit reaches its steady state level
by 2025. However I assume for this path that the desired long run debt level is
the same 12.5% of GDP as on the medium path. If public investment stays at
around the 1.5% of GDP mark projected by the OBR, then the 2020 figure for the
deficit would correspond to achieving current balance by that date.

The final path, labelled Osborne, involves the OBR’s forecasts
for the deficit under current plans for 2016 and 2017, and a zero deficit
thereafter. This brings debt down much more rapidly, and with a zero deficit the debt to GDP ratio steadily tends towards zero. I cannot see any logic to
such rapid deficit and debt reduction, so it seems to be a political ruse to
either label more reasonable adjustment paths as somehow spendthrift, or to
continue to squeeze the welfare state. What it already seems to have done is
shift the opposition's position towards the fast adjustment path.

Labour’s current commitment is to achieve a current
balance surplus as soon as possible, and certainly by 2020. If public
investment stays at around 1.5% of GDP, that would correspond to the fast path
above or even faster. It is less clear what the LibDem plans would be, either in terms
of numbers or rules, although Giles Wilkes suggests herethat they are broadly similar to Labour's plans.

There is nothing complicated in all this - anyone can produce
similar numbers on a spreadsheet. Yet they really matter. As Giles Wilkes and
also Steven Toft note, achieving deficits of the
kind shown on the fast path will be very painful unless growth is very strong.
So where is public debate about which path is more desirable? I guess it
went the same way as the public debate over austerity.
As Aditya Chakrabortty aptly observes, the fiscal policy debate at Westminster
is in danger of becoming like Monty Python's Four Yorkshiremen sketch.

Tuesday, 24 June 2014

This post presents a very simple story of the development of
macroeconomic thought from Keynes until today. It is related to a recent post from Brad DeLong on ‘economic theology’
and the neoclassical synthesis. (See also a response from Robert Waldmann.)

Economics as a science that studies markets is ideologically
neutral. Economic theory can be used to support ‘unfettered’ markets, or it can
be used to justify interventions to avoid various kinds of market failure. The
former means that it will inevitably be used by some to support a laissez-faire
ideological position. There are two checks against this one-sided presentation
of economic theory: economists presenting alternative theories that embody
imperfections, and the use of evidence to show that a particular theory works,
either in terms of its assumptions or results.

Before considering macroeconomics, take an example from labour
economics: the minimum wage. Standard competitive theory
suggests a minimum wage will reduce employment and raise unemployment. Card and Krueger undertook a famous study suggesting that in one particular example
where the minimum wage was increased there was no reduction in employment. That
led to a substantial amount of additional research, much (but by no means all)
backing up the result that the impact of moderate increases in the minimum wage
on employment was either non-existent or very small. For similar developments
in the UK, see this account by Alan Manning. This empirical
evidence was sufficient to encourage the development of alternative theoretical
models: principally but not onlymonopsony.

So here we see theory and evidence interacting in a Popperian type
way, hopefully leading to better theory. [1] Yet with economics there will
always be ideological resistance, so there will always be those who want to
stick to the basic model and who select those empirical studies that support
it. For the discipline to survive, those ideologues have to be a minority. But
even if this condition is met, a healthy discipline has to recognise the
influence of that minority, rather than try and pretend it does not exist or
does not matter.

There is a slight twist for macroeconomics. As governments are
the monopoly providers of cash, and provide a backstop to the financial system,
they are involved in the ‘market’ whether they like it or not. Complete
non-intervention is not an option: instead the next best thing (from a laissez-faire
point of view) is some kind of ‘neutral’ default policy rule, like keeping the
stock of money constant.

The Great Depression was the empirical wake-up call (the
equivalent of the Card and Krueger study) for macroeconomics. So profound was
the impact of this empirical event that it led to a whole new way of doing the
subject. Keynesian economics was methodologically different from much of
microeconomics: it put much more weight on aggregate evidence (through time
series econometrics), and much less on microeconomic theory. One way of putting
this is that in the 1960s, general equilibrium theory of the
Arrow-Debreu-McKenzie type seemed a complete contrast to what macroeconomists
were doing. That an event as powerful as the Great Depression should have had
such a profound methodological impact is not really surprising.

The Great Depression also meant that those advocating
non-intervention had to make an exception of macroeconomics. It was for the
generation after the Great Depression abundantly clear that here was a colossal
market failure. This is one sense in which the term neo-classical synthesis can
be used: to allow the state to combat the market failure represented by
Keynesian unemployment (albeit, in the case of Friedman, in as rule like way as
possible), but to maintain advocacy of non-intervention elsewhere. Note however
that this is a synthesis servicing a particular ideological point of view, rather
than being anything inherent within economics as a discipline.

Was this ‘ideological synthesis’ tenable among those supporting
the ideology? There were two natural tensions. First, the position that macro
intervention should be rule based and minimal was contestable. Second and more
importantly, as the memory of the Great Depression faded (and neoliberalism
spread), the temptation grew to ask ‘do we really have to accept the need for
state intervention at the macro level’. However I’m not sure the latter would
have become critical had it not been for another tension within macroeconomics
itself.

What was not tenable from a methodological point of view was
the distance between the very empirical orientation of macroeconomics, and the
more axiomatic foundation of much of microeconomics. What was required here was
a different kind of synthesis, one which allowed for a healthy dialogue between
theory and evidence. My impression is that in many areas of microeconomics this
happened: that is partly why I gave the minimum wage example, but it is also
worth noting that general equilibrium theory lost the primacy that it might
once had among microeconomists. But these are impressions, and I’ll happily be
corrected.

I think the same thing could
have happened in macroeconomics. Heterodox economists (and Robert Waldmann)
would almost certainly disagree, but I think macroeconomics has gained a great
deal from the project to add microfoundations. Where I hope heterodox
economists would agree is that a dialogue where theorists engaged with macroeconomics
and tried to persuade macroeconomists of the importance of following particular
theories would have been healthy. But that was not the way it turned out. What
could have been a dialogue of the Popperian kind became instead a theoretical
and methodological counter revolution. Instead of asking ‘what can we do to get
better microfoundations for sticky prices’, the assertion became ‘without good
microfoundations we should ignore sticky prices’.

Why was there a counter revolution in macro rather than a
Popperian dialogue? I think it is here that the second tension in the
‘ideological synthesis’ I identified above is important. Those who wanted to
dispute the need for macro intervention realised that the microfoundations for
macro market failures that existed at the time were poor (adaptive expectations
in a traditional Phillips curve), and so any macroeconomics based on ‘rigorous’
(textbook, imperfection free) microfoundations would not be Keynesian. They
also realised that they could produce models which generated real business
cycles which were entirely efficient. These models assumed all unemployment was
voluntary, which in any normal science would lead to their rejection, but in an
axiomatic based approach where some evidence can be ignored it was acceptable.

New Classical economics did not want to improve Keynesian
economics, but to overthrow it. It is very difficult to believe this motivation
was not ideological. Does the fact that this counter revolution was largely
successful among academic macroeconomists imply that the majority of
macroeconomists shared this ideological outlook? I suspect not. What New
Classical economists succeeded in doing was framing the issue as one where a
choice had to be made, between an eclectic empirically orientated approach
where theory was weak and empirical methods shaky, and an alternative whose
methodological foundations were solidly based within the discipline of
economics. So we moved from a position where macroeconomics and Arrow-Debreu-McKenzie
seemed worlds apart, to one where at least some see the former arising naturally from the
latter. Ironically this happened at the same time as many microeconomists saw Arrow-Debreu-McKenzie
as less relevant to what they did.

Of course we have moved on from the 1980s. Yet in some respects
we have not moved very far. With the counter revolution we swung from one
methodological extreme to the other, and we have not moved much since. The
admissibility of models still depends on their theoretical consistency rather
than consistency with evidence. It is still seen as more important when
building models of the business cycle to allow for the endogeneity of labour
supply than to allow for involuntary unemployment. What this means is that many
macroeconomists who think they are just ‘taking theory seriously’ are in fact
applying a particular theoretical view which happens to suit the ideology of
the counter revolutionaries. The key to changing that is to first accept it.

[1] By Popperian type, I just mean that a theory proves
inconsistent with data and so a better theory is developed. The Popperian ideal
where one piece of evidence (one black swan) is enough on its own to disprove a
theory is never going to apply in economics (if it applies anywhere), because
evidence is probabilistic and fragile. There are no black swans in economics.

Monday, 23 June 2014

This starts off with some rather specific politics, but we get back to some economics at the end.

This post is prompted by anarticle by Andrew Rawnsley on Labour leader Ed
Miliband’s dismal poll ratings, despite the Labour party being ahead in the
polls. Rawnsley carefully goes through possible explanations. Is it because he
is too left wing? No, the public are to the left of Labour on a number of
issues. Is it because Labour’s policies are unpopular? No, some of the policies
that have been announced have been very popular, like an energy price freeze.
So it seems to be something more personal. To quote: “Voters consistently tell
pollsters that they regard him as inexperienced, weak and incapable of being
decisive.”

Let’s take each of those in turn. Inexperienced does not wash:
as Rawnsley notes: “He has been a member of the cabinet, which is more than
either Tony Blair or David Cameron had been before they became prime minister.”
But ‘weak’ also seems inappropriate: as Neil Kinnock points out, he had the courage to take on the Murdoch press when other
politicians did not.

Wait a minute. Here we have an obvious solution to the Miliband
puzzle. The right wing press has taken everyopportunity to attack Miliband. Do people tell
pollsters that Miliband is not fit to be Prime Minister because they keepreading that he is not fit to be Prime
Minister? Rawnsley mentions this possibility, and rather than dismissing it, he
simply says that Labour has to “deal with this rather than whinge about it.” He
goes on to say

“When you know that a substantial section of the media is
looking for any opportunity to ridicule you, best not to gift them a picture of
you looking silly as you are vanquished by a bacon butty. It was even less wise
to try to truckle to those who would destroy him by sticking a daft grin on his
face and posing with a
copy of the Sun.”

For those who do not already know why that was a crass thing to do, see here. Go back to those personal failings again. Weak and incapable of
being decisive? What could appear more weak and indecisive than trying to appease the Murdoch press that is conducting a
campaign against you?

Posing with a copy of the Sun is trivial stuff, but it may be
emblematic. What is clearly lacking for Labour at the moment is what those in the US would describe as firing up the base. This is particularly important
for Labour, because it is strong among young people, but young people
tend to be cynical about politics and less likely to vote. It is why many think
David Axelrod has been brought in to help. There is also an obvious
issue that can do this job for Labour: inequality. Just as in the US, people think income and wealth should be more equally
shared, and their perceptions underestimate how much inequality
there actually is. Whether justified or not, high CEO and banker’s pay is not
popular.

When in government, Labour was strong on measures to tackle
poverty, but famously ‘relaxed’ about inequality. For some in the Labour
leadership this may have reflected their underlying beliefs,
but for others it may have been just a device to distance the party from ‘old
Labour’. If the latter, that job has been done. Shadow Chancellor Ed Balls has talked about wanting to see the benefits of
growth widely distributed, but if that is a subtle call for less inequality it
is way too coded to fire up anyone. Labour, unlike the Conservatives or
LibDems, is pledged to restore the 50p top tax rate, but it appears
only as a means of getting the deficit down.

So why does Miliband not follow Obama and put inequality centre
stage? This could achieve the twin goals of rallying those on the left, and
appearing strong and decisive. For a possible answer we can go back to Rawnsley again.
“There are senior Labour people, and not just of the Blairite persuasion, who
think that he has struck too many positions that look ‘anti-business’ and
‘anti-aspirational’. That may well put off some swing voters ….” So the advice
Miliband may be receiving is don’t mention inequality, because that might appear
anti-business and anti-aspirational. Perhaps the same people have suggested he
is photographed posing with some banking CEOs instead?

Sunday, 22 June 2014

In my drive into Oxford I pass a petrol station that offers a
car wash service. Ten or twenty years ago you would have expected this to
involve a large degree of automation. However in this particular case it
involves a few workers with hoses, mops and buckets. Now anyone who has seen my
own car will realise that I know very little about car cleaning technology. But
with this caveat, it seems to me this garage offers a nice illustration of how
labour productivity is a function of relative prices. If labour becomes
expensive relative to capital, it is worth the garage investing in a car
washing machine, but if the opposite happens, once the machine reaches the end
of its life it goes back to the old labour based technology.

In technical terms what I describe above is just an example of factor substitution. This is one explanation
of the UK’s productivity puzzle, investigated
at the aggregate level by Joao Paulo Pessoa and John Van Reenen. They “argue
that ‘capital shallowing’ (i.e. the fall in the capital-labour ratio) could be
the main reason for [the productivity puzzle]”. Although initially the US did
not see productivity fall, there are indications a milder form of this may be
happening there too.

So why does this not happen in every recession? One answer,
provided by Pessoa and Van Reenen, is that the behaviour of real wages in this
recession has been very different. Real wages have been much more responsive to
unemployment in this recession compared to the recessions of the 1980s or
1990s. Pessoa and Van Reenen suggest this could be the result of a combination
of weaker union power and welfare reforms that keep effective labour supply
high even when demand is low. You could also add greater availability of cheap
labour from members of the EU where unemployment is high.

A counter argument might be that earlier recessions have been
caused by tighter monetary policy, pushing up the cost of capital, whereas in the
Great Recession interest rates have been at the zero lower bound. However there
is evidence that the Great Recession has increased the
cost of capital for large firms in the UK, and the impact on small firms will
have been even greater. In addition a recession that involves a financial
crisis is likely to leave firms feeling particularly reluctant
to invest, because any borrowing will involve a long term financial commitment
that leaves them more vulnerable. In the past they could have relied on their
bank to see them over any temporary cash-flow problems, but now they are less
sure. In these circumstances, labour intensive rather than capital intensive
forms of production seem much less risky.

Indeed in a world of certainty the capital intensive form of
production might actually be more efficient. In economic jargon, switching to
people with buckets and hoses has actually reduced total factor productivity.
But in a world where financial risk has increased, the firm may still choose
the labour intensive form of production.

This process of factor substitution will also lead to a steady
decline in survey measures of excess capacity. As the recession hits, the car
wash business with a large machine will report excess capacity as people
economise on car cleaning. However when the machine reaches the end of its
useful life, it is replaced by people with buckets and hoses, and the firm
reports no spare capacity.

What happens when demand begins to rise? Initially not much -
the firm just hires more labour. Productivity does not increase. The situation
becomes more interesting if labour becomes scarce. Does the firm start paying
higher wages to attract more workers, or push up prices to choke off additional
demand? Or does the firm now think that maybe it is time to invest in a car
washing machine, which would in a more certain future allow the firm to reduce
costs and prices (and lead to a reversal in the fall in productivity)?

Perhaps all of the above. But suppose that at the moment real
wages or inflation begin to rise, the central bank tightens monetary policy.
This would raise the cost of capital, and could be interpreted as an attempt to
prevent real wages rising. In other words, a strong signal to the firm to stick
with its labour intensive production methods. We enter a kind of low
productivity, low wage trap. Monetary policy, which in theory is just keeping
inflation under control, is in fact keeping real wages and productivity low.

Monetary policy makers would describe this as unfair and even
outlandish. A gradual rise in interest rates, begun before inflation exceeds
its target, is designed to maintain a stable environment. As the owners of the
garage begin to appreciate this, they will eventually decide to invest in that
car washing machine. On the other hand, if they sense that inflation might rise
above target, they will not invest, however strong short term growth might be.

I’m not sure I believe this. As Chris Dillow argues here, investment may be particularly prone to
confidence or animal spirits. Would these animal spirits be stimulated more by
strong demand growth, even if it was accompanied by forecasts of 3% or 4% inflation, or by monetary tightening to
prevent this inflation ever happening?

I also have another concern about a monetary policy which tightens as soon as real wages start increasing. What little I know about economic history suggests an additional dynamic. As long as the firm is employing labour rather than buying a machine, there is no incentive for anyone to improve the productivity of machines. The economy where real wages and labour productivity stay low may also be an economy where innovation slows down. The low productivity economy becomes the low productivity growth economy.

Saturday, 21 June 2014

Jonathan Portes and I have an article in Prospect, which is a short summary
of our discussion paper on fiscal rules (see here
or here).
In this post I want to use that paper to make two observations on the
interaction of politics and economics.

Jonathan and I are frequently accused of being against fiscal austerity
for political or quasi-political reasons: either we dislike governments that
impose austerity, or we want to increase public spending and think that by
advocating temporary increases in government investment at the zero lower bound
we can achieve this goal. In which case we would obviously reject any fiscal
rule formulated by this government, and more generally we would be against any
kind of discipline on public debt or deficits.

If that is what you think, the Prospect article or the
discussion paper will have you scratching your head. After a thorough analysis
of the principles behind fiscal rules (on which more below), we conclude that
the form of the coalitions current fiscal mandate is about right. It makes
sense to have an operational target for the deficit rather than debt, and it
makes sense to target that deficit always looking five years ahead.

There is one huge caveat, which is that this form of rule is
appropriate as long as interest rates are not at, or expected to be at, their
zero lower bound. In this recent post I outline what we recommend in our paper should
happen in those circumstances, and of course current governments have (since
2010) failed to follow this advice. So our endorsement of the form of the current fiscal mandate only
applies to when monetary policy can operate in a normal fashion.

Our paper also endorses another innovation of the current UK
government: the formation of the OBR. In fact we suggest that it should have
additional duties. So these two structural changes brought in by the coalition, the fiscal mandate and the OBR, were positive innovations. The tragedy is that the former was
applied in the one circumstance in which it should have been (temporarily)
abandoned.

Of course the form of
the fiscal mandate is different from the actual numbers targeted for the
deficit in five years time, and I will talk about those in a subsequent post.
We also have some minor suggestions to improve the rule: for example if you are
targeting a deficit in five years time when monetary policy is working
normally, the target does not need to be cyclically adjusted, and we would
target the deficit (actual or primary) rather than the current balance, and
have a separate target for the share of public investment in GDP.

There is a second sense in which our paper directly addresses
the interaction between economics and politics. The way I began thinking about
fiscal rules was a standard way macroeconomists think about rules: how close
are they to the optimal policy that would be chosen by a benevolent policy
maker? This is a perfectly sensible question to ask, but for fiscal policy it
is on its own hopelessly incomplete, because we also know that politicians are
often not benevolent, in the sense that they act in their own interests rather
than in the interests of society as a whole. As a result, we get deficit bias, although this bias may occur for
other reasons. The role of fiscal rules is to a large extent to discourage this
non-benevolent behaviour.

Take the current UK fiscal mandate, for example. An obvious
criticism is that, by always targeting the deficit five years ahead, it allows
a government to keep putting off making the adjustments required to achieve the
target. Don’t worry that the deficit is above target, a government might say,
in five years time it will be on target. And it could carry on saying that year
after year. In the paper we say that this rule lacks an ‘implementation
incentive’.

So why not make the target for some fixed date in the future,
so adjustments cannot be continually delayed. The problem with a rule of that
kind is that it can produce very sub-optimal behaviour as we approach the fixed
date. Our macroeconomic theory says that the deficit should be a shock
absorber, so having to achieve a target at a fixed date whatever shocks hit the
economy could be harmful when unexpected shocks occur near that date. Imagine how much worse
austerity would have been if the government had tried to achieve current
balance by 2015.

Fiscal rules therefore involve a trade-off between optimality
and effectiveness in preventing non-benevolent behaviour and deficit bias. The
latter depends on a political judgement about policymakers. For the UK, both
past evidence and current behaviour suggests that deficit bias is not a huge
problem, which is why the rolling five year deficit target can work, but in
other countries it might not. This is where a fiscal council like an enhanced
OBR can be very useful.

Even the more responsible governments are tempted by devices
that allow spending today but which shifts costs into the future (PFI in the UK for example). It is very
difficult to devise fiscal rules that involve ‘operational targets’ (i.e.
targets that a government can try to meet during its term of office) but also prevent
such tricks. This is an important reason to do long term fiscal forecasts,
undertaken or assessed by independent institutions, which is where the costs of
such schemes become evident. However that alone is not enough. A fiscal council
like the OBR should also have a duty to clearly alert the public when such tricks
are being played. In addition, when targets are flexible so that the
implementation incentive is weak (as in the case of a rolling five year target
like the UK fiscal mandate), fiscal councils should also judge on behalf of the
public whether meeting the target is being delayed for justifiable reasons or
not.

So the choice of a fiscal rule and the mandate of a fiscal
council inevitably involve political as well economic issues. However the
politics is more about the transparency and accountability of government,
rather than left versus right and associated ideologies.

Friday, 20 June 2014

When the current government took over in 2010, the UK economy
had begun to recover from the Great Recession. In 2010 Q2, real GDP was about
2% higher than a year earlier. The new government embarked on a programme of
enhanced fiscal consolidation (austerity). Growth over the next two years was
less than 0.4% at an annual rate. The imminent debt crisis that was supposed to
justify austerity never materialised - interest rates on government debt fell
significantly.

On the face of it, this looks rather bad for the government. So
it has been really important for its spin masters to manufacture a consensus
that there was no serious alternative to this policy. This has involved three
strands. First, that the recession was somehow the result of the previous
government’s fiscal profligacy. Second, following on from this, that the
government therefore had to ‘clean up the mess’ - austerity was inevitable.
Third, that the economic recovery, when it came, was the reward for austerity.

The first strand is untenable. Yes, fiscal policy might have been
tighter after 2000, particularly if we had known what we know now. But it
played no part in causing the Great Recession. The second strand therefore does
not follow. Among informed commentators on the UK economy, there is certainly
no consensus that austerity was necessary. The third strand is complete and
utter nonsense. To suggest that this story is self
evident is a lie. So how did the government manage to convince almost everyone
to accept the story as true?

First, it was vital that other governments were telling similar
stories, and that real debt crises were happening not too far way. The idea
that the Eurozone crisis is all about
fiscal profligacy is equally untrue, but Greece provided the cover. Second,
economists in the City tended to go along with the story, in part because it was in the interests of finance to
do so. Third, most journalists and newspapers were happy to toe the party line. The
occasional eminent journalist or academic would complain, and the Prime
Minister revealingly described them as ‘dangerous voices’, but in
truth they would only become dangerous if the political class took them
seriously. They did not, as we shall see. The ultimate success of the lie was
that political opposition to austerity died away.

There was just a little tidying up to do for the spin masters.
The IMF had originally supported the 2010 austerity programme, but soon began
to have doubts. As the economy continued to stagnate, those doubts grew more
vocal. The IMF has an authority which really was dangerous. So when everyone,
including the IMF, failed to forecast the strength of the 2013 recovery, the
spin masters saw their opportunity. Before the 2014 Article IV assessment, they
put out the line that the IMF really should apologise to the government for
getting its forecast so wrong, and for daring to criticise the need for
austerity.

Ashoka Mody systematically takes apart the idea that the IMF should apologise. But what was interesting for me was the idea that they should apologise ever got traction in the media. Please correct me if I’m wrong, but I do not remember a BBC interviewer ever asking the Managing Director of the IMF, or anyone else from the IMF for that matter, to apologise to the government before. It was so obviously an idea put out by the government in an attempt to stifle future criticism by the IMF, about policies like Help to Buy for example. The fact that newspapers and then a seasoned political interviewer on the BBC faithfully repeated it shows how dominant the austerity lie has become.

Thursday, 19 June 2014

If you do not like the
sporting metaphors in the post below, you can blame new MPC member Andy Haldane
whose speech I have just read. Or maybe the World Cup.

When it comes to monetary policy, in recent years the UK has
consistently followed the US. The US Fed started reducing interest rates in
September 2007, and hit the Zero Lower Bound (ZLB) at the end of 2008. The UK’s
MPC started reducing interest rates in October 2008, and hit the ZLB in March
2009. The lag between the two shortened considerably with Quantitative Easing,
which the UK started just two months after the US. The MPC also followed the
Fed with forward guidance, using a very similar formula.

The big question today for monetary policy in both the US and
UK is when interest rates will start to increase. Until very recently this
looked like a race that neither central bank was keen to enter, at least for a
while. But that all changed last week following a speech by UK
Governor Mark Carney. That led Gavyn Davies to ask what implications UK hawkishness might
have on the US. It is very easy with such things to get lost in the immediacy
of each new data release. In this post I’ll try and focus on the fundamentals.

Both central banks prioritise price inflation. UK inflation
remains comfortably below target at 1.5%. US inflation had been in similar
territory. The CPI rose by slightly more than 2% in May, but that is more
volatile than the measure the Fed targets, so it is too soon to know whether
this represents the beginning of a return of inflation to target. The FOMC
committee’s latest forecasts indicate that inflation will remain below target
for some time.

If the May CPI figure in the US turns out to be a blip, then
there appears to be no immediate pressure to raise rates. However interest rate
changes take time to feed through to inflation. As a result both central banks
would like to start raising rates before rather than after the underlying level
of inflation starts to exceed its target. Whether this is a sensible strategy I
will discuss later, but it means the focus in both countries is on what
determines future price inflation.

Here the UK seems to be in the lead, with stronger GDP growth
than in the US. However economies often grow very rapidly when emerging from a
deep recession. US growth was strong in 2010, but the Fed did not start raising
rates then. The US has been growing at a moderate pace ever since, while the UK
economy stagnated in 2011 and 2012. With this perspective, the US has not
raised rates even after 5 years of recovery, so it seems odd that the UK should
raise rates after just two years.

Economists would normally say that the more relevant measure
for inflation is the output gap: an estimate of how much actual GDP is below
the level at which inflation would be stable. Here most estimates suggest the
UK is ‘winning’: the latest OECD Economic Outlook estimates for 2014 are UK -1%
and US -3.1%. Now output gap estimates should normally be taken with a pinch of
salt, but for the UK in recent years this pinch has become a spoonful. Most UK
estimates assume that the marked decline in UK productivity growth since the
recession (the UK ‘productivity puzzle’) is largely permanent. But as no one has
any idea about why this decline has happened (hence puzzle), there is no
compelling reason to assume it is permanent rather than reversible.

We can make the same point in a very simple way. UK output is
currently around the same level as it was in January
2008, while US output is over 6% above its pre-recession peak. This would
normally imply that the UK should be following well behind the US in raising
rates.

What about the labour market? Here is a chart comparing
unemployment in both countries.

I have taken the OECD’s latest Economic Outlook forecast for
the US, but I have used much more optimistic numbers for the UK: 6.4% for 2014,
and 5.7% for 2015. (Unemployment in May was 6.6%.) It is true that for
unemployment, the lag between the UK recovery and the US recovery is shorter
than for GDP growth. However they seem to be in similar territory at the
moment, with unemployment unlikely to return to 2000-2007 numbers by 2015. In
addition, there may be more labour market slack than is implied by these
numbers, although for different reasons in each country. One final
point worth noting is that, with free movement of labour
within the EU, any labour market pressure in the UK can be offset by inward
migration as long as Eurozone unemployment remains high.

There is no indication of any tightening in the labour market
in either economy from data on wages. In the US real wages are stagnant, and wage growth in the UK continues to be below price inflation. In the
UK, there is even some doubt whether rising real wages would put that much
upward pressure on price inflation. Some part of the UK productivity puzzle must be
the result of factor substitution: using labour rather than machines because
real wages are low relative to the cost of capital. If that is the case, there
is scope to reverse this if real wages start to rise, meaning that wage
increases are not fully passed on into prices.

One area which is often talked about where the UK is well ahead
is the housing market, with UK prices rising rapidly. House prices are not part of
the consumer prices index, but some argue that they should be. This is
problematic conceptually - rents are the price of housing services, and house
prices are the price of an asset. As I pointed out here, what we have in the UK
at the moment is a rise in house prices relative to rents, which may in turn
reflect the combination of falling interest rates and static supply, plus
perhaps a bit of froth on top. According to the ONS
data, rents have not been rising rapidly since the recession.

As John Williams among many others have emphasised, using
interest rates to calm the housing market when inflation is below target has
proved disastrous for Sweden and Norway. A housing boom is not a reliable
indicator of incipient inflation. The UK should certainly not follow the
Scandinavian example in this particular respect.

Taking all this together, who will be the first to raise rates?
My feeling is that US monetary policy makers are on reasonably solid ground,
and are not even in their starting blocks. The output
gap in the US is sufficiently large that there is little need to start raising
rates now. UK monetary policy makers are in a much more difficult place,
because of the UK productivity puzzle. The Carney speech has in effect
tightened monetary policy by appreciating the exchange rate, as he must have
known it would. Before this I had hoped that they would at least wait until real
wages started rising significantly, but now I’m less sure. I fear after the
Carney speech that they have entered the starting blocks, and any noise might
trigger a false start.

The problem for the UK is that the strategy of wanting to start
raising rates before inflation exceeds the target is inappropriate given the
extreme uncertainties implied by the productivity puzzle. As Mark Thoma explains, and I have argued before, the risks
are not symmetric. It would be unfortunate if inflation started rising before
interest rates started increasing, but the costs of a few years of excess
inflation would not be that great. The MPC has after all been there recently,
and the world did not come to an end. The costs of prematurely choking off a
recovery are much greater when recent productivity and output losses might be
recoverable (as they were in the early 1980s and 1990s). These are very strong
grounds for the Bank of England to continue to follow the US Fed, and not jump
the gun.

Postscript: Tony Yates elaborates on this last point, and also has more on the Haldane speech.